It has been a bit since I have collected together my thoughts and observations on the market, the economy, and implications for financial planning best practice.  Some of this post will get technical and long winded, so I will try to capture the headline level here at the top.

As of this writing, the S&P is still about 14% below the market highs in mid February, and about 9% below the start of the year.  That reflects a remarkable "bounce back" from the lowest numbers in March [approximately +31% from March 23 to today].  As a participant in the markets as an investment manager and investor of my own funds, I certainly appreciate this bounce.  But I retain a significant amount of skepticism about the economics underlying the market.
So if there is a prime takeaway from this post, it is that I expect additional volatility in the weeks and months to come.
I will stay invested and will counsel my clients to stay invested, but in a posture that reflects the economic reality and in line with each person's specific goals and tolerance for risk.
​Now, to the data, observations, and insights.

The Congressional Budget Office is projecting significant contraction in the US economy through the COVID 19 pandemic.

The Q1 numbers are already behind us, and the projected drop in GDP to NEGATIVE 39.6 is expected to lead to a negative real growth rate for the year of ~ 5.6%

Against this backdrop of expected economic contraction, the stock market (at least as represented by the S&P 500 index) has regained a lot of ground lost during the "shut down".  If you dial out the perspective to a 12 month or longer view on the index, returns are now positive -- from May 22, 2019 to today, the S&P is up about 2.75%.  This disconnect between the market and the economic data can be jarring and confusing, and often leads to the invocation that "the market is not the economy".  They aren't the same, but are related.

Stock market investors are generally assumed to be buying into a share of future net income from the companies they choose to own.  The earnings from any given company can diverge from the broader economy in the short term, and for a very limited number of companies that diverge could persist for a while, but my expectation is that over time, the valuation of a company's stock should reflect the economy that they operate within.

I will continue to maintain a humble awareness that I cannot know anything for sure about the present or future state(s) of the financial markets, but I can make some informed guesses about pieces of it.
It is a reasonable question to ask: if the economy is really hurt, why would the stock market go up?
From where I sit, there are two primary drivers of the index valuation since mid March: cash from the government (& Fed), and outsized index constituents.

This chart shows the "balance sheet" of the Federal Reserve going back to the early 2000s.  The shaded bar covers the period of the "financial crisis" or "Great Recession", and that sharp uptick in the chart was when the "bailouts" and "quantitative easing" and other financial interventions happened.  The Fed's balance sheet doubled in that phase, from just under one TRILLION dollars to more than two.  The Fed remained invested in the market at elevated levels, creeping up over time to about $4.5T, and then in March of this year jumped about 75% to ~ $7 trillion.

We throw around big numbers a lot in discussions of financial markets and the economy, so it may help to put ~ $2.5T to $3T in context.  The image below shows the (2018) GDPs for Germany, Italy, and France:

So far this year, the Federal Reserve has injected cash to our economy roughly double the entire GDP of France (and 3/4 of our own GDP from 2018).

For another comparison that also leads to my next point, the largest companies in the US are all grouped roughly around $1T in "market capitalization".  Apple, Amazon, Microsoft, and Google are all valued at +/- $1T in the current market -- the Fed pumped the rough equivalent of two to three "Googles" into the economy in a matter of weeks.

Those four stocks also play a role in my understanding of the current index valuation.  I will focus on just one as an example here, but all four are shown in the chart below.

Microsoft is up more than 16% year to date, maybe because people are relying more on their cloud products during "work from home" or buying Xboxes or whatever.  The WHY is less important than the WHAT for the moment.  At present, MSFT makes up about 5.6% of the whole S&P 500.  In a overly simplified calculation, about 90 basis points of the S&P's return for 2020 so far comes from Microsoft.  If you took MSFT out of the index, instead of the S&P being "down" about 8.9% on the year, it would be down about 9.75%.

Apple, Microsoft, Google, and Amazon are the largest components of the S&P, and all are up big over the last few months, and up even more over the last year.  Removing their contributions from the index makes the overall "stock market" returns look very different.  This dynamic is one reason that my approach to investing is inclined to the use of "index funds" and away from picking or holding individual stocks for most clients.  It is VERY difficult to know well in advance which small handful of stocks is going to do well in any given cycle, and marginally less hard to guess whether or not the "whole market" is going to rise or fall.  For today's post, the point about MSFT et al is that they are experiencing outsized returns during the pandemic and because they are huge contributors to the index valuation, those outsized returns are propping up the "market" in a meaningful way.

Over the last few weeks I have been revisiting "professional" market projections from late 2019, well before the COVID 19 crisis was on anyone's RADAR.  Banks and financial market participants like Morgan Stanley, Vanguard, etc all put out their capital market assumptions for the coming cycle, and the projections made in the 4th quarter of 2019 were...lackluster?  Many of the projections were cautioning investors to prepare for "real" (meaning inflation adjusted) returns of less than 4% or 5% annualized for a number of years.
It is entirely possible that those numbers anticipated some number of "shocks" to the economy and the markets, but I strongly suspect that none of those projections figured on a calendar 2020 with negative GDP growth of 5% to 6%.

So in the context, I am trying to plan and position for subdued equity returns in the overall market, and looking for opportunities to create and realize value in that environment.

I would be remiss to ignore interest rates in this discussion.  Just this week, the UK issued a new three year bond at "negative yields", and the US issued a new 20 year treasury bond at about 1.2%.  Overall interest rates remain at or near historic lows, and part of the Federal Reserve's growing balance sheet came through purchases of corporate and municipal bond funds, providing some pricing support (and lower yields) in those markets.  While it is tempting to say things like "interest rates CAN'T go lower", that would be irresponsible and unsupported by the data.  I DO tend to believe that interest rates will rise from here, but am obliged to plan for a variety of paths forward, including some version of sustained "zero interest rate policy"

If you have a robust financial plan, now is probably the time to focus on executing that plan.  Reviewing asset allocations, identifying tax improvement opportunities, refreshing estate planning and asset location strategies -- these may all be productive steps to take during the present "crisis".

If you DO NOT have a robust financial plan, it is past time to address that gap.  Whether with DRW Financial or another professional offering advice as a fiduciary, having a plan in place should increase confidence that your particular goals are addressed.

Target retirement date mutual funds have become a mainstay of employer sponsored retirement plans (401k plans, for example), and many retail investors are choosing these options as well for their simplicity.  The general idea of a target date fund (TDF) is that the fund holds a mix of assets - -mostly stocks and bonds -- in proportions that shift over time to lower the portfolio's expected volatility into the retirement date.

In overly simplistic terms, this means that a far off target date fund will hold mostly stocks, and a very close target date fund will hold a relatively high proportion of bonds.

For one example, consider the Vanguard Target Retirement 2040 fund, symbol VFORX: 

This fund is meant for investors who believe that the year 2040 is likely when they will begin taking retirement distributions from their savings, or at least represent the amount of risk they want to take with those savings in the present.

The Vanguard page for this fund also shows the underlying funds that make up the TDF:

For this blog post, I want to focus on the bond allocations within this fund.  We can get more information on each, as they trade independently of the TDF under the symbols VTBIX and VTIBX.  For further simplicity here, I will focus solely on the domestic fund, VTBIX.

The rationale for holding bonds in a "diversified" portfolio along with stocks is that they historically represent different types of risk, and they typically respond differently to major shifts in the market's perception of risk.  Often, in times of distress for the stock market, some investors will shift some of their money from stocks to bonds in pursuit of more stability or predictability, and this shift may raise the prices of bonds temporarily.

And this general dynamic played out in the recent stock market correction related to the COVID 19 virus -- stocks fell, and at first bonds of almost every type rose.  A subsequent wave of market reactions pushed US Treasury bonds higher still, but bonds of almost every other type (corporate bonds, municipal bonds, mortgage backed bonds, etc) fell a considerable amount as the market adjusted to consider the risk of those bond issuers "defaulting" on their obligations.  For example, investors were forced to consider if bonds backed by a particular retailer or airline or car company would pay as expected if those companies were forced to close or go into bankruptcy.

The chart below is clipped from CNBC, and shows the "year to date" price of the bond fund.  That peak in early March, the sell off over the next two weeks, and the rebound up to today all match the general pattern of bonds in the market (except for US Treasuries which saw a much more muted sell off in mid-March)

This all leads to the inspiration for today's post: what does it mean to continue to hold bonds in the current market?  Will bonds continue to provide the volatility dampening effect as per historical precedent?

Pulling together fact sheets, prospectuses, and other resources on this particular Vanguard fund suggests that the current composition of underlying bonds is roughly 44% US Treasuries, with another 22% in mortgage backed bonds from "government sponsored entities" like Fannie Mae and Freddie Mac.

In the current environment, the Federal Reserve is actively buying up those two categories of bonds to provide support and liquidity to the market -- this means, that all else held equal, the prices of those categories of bonds are being pushed higher and their yields pushed lower.

For the VTBIX fund, the SEC Yield is currently just under 2%, and the distribution yield just over 2.5% -- but the underlying "yield to maturity" of the bonds held by the fund is ~ 1.70%, an average duration of more than 6 years, and an average maturity of more than 8 years.  Taken all together, an investor holding this fund (or one very similar) may want to consider the possible paths for forward for economic gain in the fund, or the ways this holding may contribute to the overall performance of their portfolio.

The "total return" of a bond or bond fund is made up of cash flows and price movement.  As in the chart shown above, an investor buying the VTBIX fund on March 17 or so would have experienced a rise in price in addition to whatever dividends and interest the fund paid out during the holding period.  And an investor holding that fund from March 7 to March 20 would have seen a meaningful shift to a lower price.

A question I am asking myself and on behalf of my clients in this market is what may I rationally expect for bond and bond fund prices looking forward?

The recent collapse in US bond yields to all-time historic lows presents an opportunity and an obligation to review the prevailing yield to maturity (and yield to "worst") of the bond and "fixed income" portions of an investment portfolio.

We know that bond prices and yields are inversely related, at least for bonds with fixed coupons and no call features.  As yields rise, prices fall; as yields fall, prices rise, all else held equal.

In asset allocation theory, an investor may hold bonds as a sort of counter-weight to stocks -- while stock and bond prices may move together and in the same direction at times, when volatility in the market rises and stock prices fall due to perceived risk, bond prices tend to rise as investors seek more stability in more predictable investments.

That dynamic has played out in the US investment markets over the last few weeks as the major stock indices have fallen by double digit percentages.

The value of an individual bond is set by its yield.  That is, the market sets a yield for the risk associated with that bond, and the price is calculated from that yield.  A bond can have several different yield measures: yield to call, yield to maturity, yield to worst...From the perspective of the investor holding a bond, the "yield to worst" may best capture their economic opportunity.  Bond funds do not behave exactly like individual bonds, but the value of a bond fund should relate to the underlying value of the bonds it holds.

An investor who buys a bond or bond fund and then sees the relevant market yield for that investment fall should see the price of their investment rise, and so is presented with an opportunity to continue holding the investment or selling it at a gain.  The decision between those options will require some analysis and will depend on the investor's particular circumstances.

When an investor buys a bond or bond fund, the yield to maturity on that day and at the price they pay does matter -- it establishes a basis and informs the expected holding period return if the bond is held to maturity.  But as the price of the investment changes and the term to maturity decreases, the prevailing or mark-to-market yield to maturity (and yield to worst) also matter a great deal, but are often overlooked by investors and their advisers.

Consider an example where a client buys a bond of SAMPLE COMPANY to yield 4% for 10 years, and in a few months finds that the market has set a new, lower yield for that bond at 2.5%...this would mean that the price of the bond would have risen to set the market yield for the bond at ~ 2.5% -- the investor could sell the bond at a capital gain to other investors who want the 2.5% yield.

Why would a person sell in this situation?  If their original goal was to earn 4% returns on their money, they may not be content to "only" earn 2.5%, but that is the remaining opportunity for that investor over the term of the bond.

As of 10am this morning, the US stock markets look headed for another significant drop.  The Dow Jones Industrial index is down more than 1.5% on the day, bouncing between -450 and -650 points, depending on when you look; the S&P 500 is down almost 2%.

This is a chart showing those two index levels over the last 12 months:

The numbers in the chart may be hard to read -- they show that current prices versus a year ago are still "up", with the Dow and S&P showing gains of 7.5% and 15.5% respectively for that period.

The next image shows the price movement for two bond funds for the same period, one tracking a wide variety of bonds, and the other a tighter selection of US government bonds of intermediate term:

Those investments ALSO show significant gains for the period, and show the effects of a "flight to quality" i the last few days as the stock market volatility has ramped up.  And speaking of volatility, here's a look at the VIX index, which represents one measure of market volatility:

The recent spike is moderately higher than similar spikes in February and December of 2018, but still less than half the levels seen in 2008 during the "crisis".

I will continue to refrain from suggesting that I know with certainty the "why" of any given event in the markets, but I'm comfortable assuming that this activity has at least some source in the Coronavirus news.  The value of any given stock relies implicitly on that company's likelihood of realizing profits, and the market trying to assign a "present value" to a future stream of those profits.  When something happens to introduce increased uncertainty about those profits, the market reacts by widening their range of assumptions, and essentially by design tend to "overshoot" the estimates for how bad (or good) things may turn out.

Because this particular virus is "new", and we don't know precisely how widely it will spread and how disruptive the spread will be to different parts of the economy, large market participants are reacting by dramatically widening their math on future profits.  When more information comes in, the market will likely tighten their assumptions again and the market will settle into a more stable range of prices; what we don't know is if that more stable range will be higher/lower/similar to where we were just before the virus hit.

For my own investments, and those I manage for my clients, my intention is to maintain a risk appropriate posture; for goals with "long" time horizons, like retirement 10 or 20 or 30 years out, I will continue to hold portfolios weighted to stocks, with a smaller allocation to bonds, cash, etc.  For shorter goals, I will continue to hold bonds, cash, and short term instruments in incrementally higher proportions to constrain the overall portfolio volatility.

This week and next I will look for opportunities to tactically realize "tax losses" if they are valuable to my clients; I will review if specific index tracking funds performed as expected; I will use cash flows from dividends and interest to make  tactical reinvestments; and I will rebalance portfolios that have drifted away from the client's designated plan.

​Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity [T10Y2Y], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10Y2Y, September 4, 2018.

Market participants may read many portents into a flattening or inverted yield curve.  Some common concerns are that a curve that deviates from the norm in this way suggests that a recession is likely in the near future.  A more concrete view is to consider how the actions of the Federal Reserve propagate out through the bond market. In the recent case, the Fed has raised their funds target several times, which led to the short end of the market rising too (see the 3 month Bill rate above).  The points on the curve further out, such as at the ten year and thirty year spots, have not yet priced in the likelihood of higher inflation or the Fed funds target to sustain in the current range. So the short end yields are up, but the longer yields have risen less on a relative basis; this leads to a flatter curve.

Notes and disclaimers

The Federal Reserve Bank of St. Louis provides an excellent resource for economic data; the charts and figures for this article are all sourced from FRED.

This article is intended for educational purposes only, and is not a solicitation to buy or sell any security or investment.  Investors should consult with a qualified professional, and carefully consider the risks and potential rewards of any investment strategy prior to making an investment.

Why did the market "go down" in late January, 2018?  There are many possible reasons, and most of the time a substantial move in the market is really about a combination of things (if there is any real reason at all).

My current vote for the "biggest" reason for this particular fall in the price of stocks is what was happening in the bond market, which was itself reacting to what was happening with the Federal Reserve policy, which was itself...complicated.

In brief, the Federal Reserve in the United States has a few main purposes, which are often reduced to the "dual mandate" of promoting employment and moderating interest rates.  The entire financial system relates more or less directly to the cost of money over time (aka interest rates), and inflation is a major consideration in how the markets set appropriate interest rates for a given investment or transaction.

Again, speaking in simple terms here, for an investment to yield an economic gain to the investor, the realized return must be greater than the rate of inflation for the same period.  If not, the investor is actually losing "purchasing power".  For example, if I have $1 today and a can of soda costs $0.50, I can buy two cans.  If I wait a few days, and the price of the soda rises to $0.55 but my $1 is still just $1, I can no longer buy two cans...the purchasing power of my dollar has eroded due to inflation.

In January of this year, two things seemed to come together to jolt the market: (1) the major US stock indices were setting records for the longest period without a "correction"; and (2) the Chairwoman of the Fed was stepping down and aside for her successor.  My view is that these two factors were causing the market to process what might happen with inflation, both from pressure of a "hot" stock market, and from the relative uncertainty as to how the new Chairman would respond to that pressure.

The US has enjoyed a very long period of relatively tame inflation, and the prospect of a quicker increase in consumer prices can be unsettling.

For investors (which includes normal folks looking to properly manage their retirement savings), the task of how to best position themselves in a period of rising inflation can be challenging.  Here are a few points to consider:

• "Fixed income", as a category, tends to fair poorly in an inflationary cycle.  Some potential strategies:
  • Longer term bonds tend are generally worse off when inflation strikes, so it may make sense to look at the maturities and duration of the bonds in the portfolio.  In the case of bond mutual funds or ETFs, look at the segment of the bond market the fund targets to get an idea of the average maturity or duration; better yet, pull up the details of the individual holdings
  • Shorter term bonds and well structured "bond ladders" may still perform as intended in the portfolio; if rates are rising, as the short term bonds come due, it may be possible to reinvest the proceeds into higher yielding options, as appropriate
  • Certain sectors and types of bonds are especially sensitive to rising inflation and market rates; "preferred stocks", for instance, tend to exhibit high sensitivity in this type of cycle.  Similarly, "zero coupon" bonds, or STRIPS, or even regular bonds with relatively low coupons (think < 2.5% - 3% in the current market) will all take a big hit on value in a rising rates market
  • Annuity products with a fixed accrual rate, or a fixed minimum annual "return" may be especially costly when facing inflation.  These insurance products tend to come with significant expenses to hold, and don't "mature" in the way that short term bonds do.  Depending on surrender periods, the tax impacts of withdrawing, and opportunities to "exchange" into other annuity products, there may be a relatively attractive option to exit a low rate product in an inflationary cycle
  • Both the US treasury markets and the corporate bond markets now have "inflation adjusted" bond offerings; these may perform better as a hedge to hold relative value than as a place to find gains, but may play a role within a broader portfolio
• Stocks and returns in the stock market are also subject to eroded economic gains if inflation gets out of control
  • Some stocks have historically behaved as a sort of proxy for "fixed income"; utility stocks are an example that some investors hold primarily for their relatively steady stream of dividends.  The issue here is that many utility companies are not free to raise prices to match inflation, which may limit their ability to raise their dividend payment rate.
  • In recent cycles of rising rates, emerging market stocks showed sensitivity to rising rates and Fed policy; it may prove prudent to review the allocation to this sector
  • Some companies stand to benefit from rising prices, particularly in industries where the profit margins rise along with prices.  It can be useful to consider whether a sector or individual company belongs to that camp, or are in the position of being squeezed on profits when their input prices rise due to inflation.
• Over the long term, residential real estate seems to have kept pace with inflation.  However, investment products tied to the real estate markets may be complicated by holding exposures to home builders, construction supply companies, etc that draw their own value from economic activity related to real estate and not necessarily from the property values themselves.  Further, real estate related investments tend to show some sensitivity to interest rates due to the impact of higher mortgage rates on the ability or desire for people to get a home loan.
• Other assets, like gold or various commodities, exhibit complicated relationships with inflation and interest rates that are difficult to model in an actionable way when designing a portfolio
• Holding cash into an inflationary cycle may provide an opportunity for tactical allocations into investments that match the investor's goals and risk tolerances; putting "extra" cash to work after a dip in price for those investments could be advantageous.  However, holding cash for an extended period while prices are rising will definitely lead to that loss of purchasing power as described above

DRW Financial is happy to provide an initial consultation and portfolio review to residents of Tennessee, Illinois, and Georgia at no cost.  Email David@DRWFinancial.com or complete the contact form at this link for more information.

Let's get two things out of the way early: (1) there is a lot of noise in the news right now about Bitcoin and its crypto-cousins (and too little information, in my humble opinion), (2) this post is a contribution to the noise, but hopefully contains a little information relevant to my client base and readers.

There are plenty of articles going around about what crypto currencies are supposed to be, and how blockchain technology is meant to work, so I will keep my comments on this aspect super brief.  The blockchain is sometimes referred to as a "distributed ledger" for financial transactions, which can in many ways bypass the existing infrastructure of banks and payment processors and clearance / settlement facilities currently involved in exchanges of value between parties.  And while this ledger is maintained and processed in a relatively "public" way by market participants, individual participants are able to act in a relatively anonymous way.
Bitcoin is a medium of exchange on one version of blockchain, and it follows a very specific protocol or set of rules about how new Bitcoins can be introduced to the market and how transactions in Bitcoin between parties can be processed (this activity is collectively referred to as "mining").
Bitcoin itself has "forked" into some new variants that have expanded or refined protocols that attempt to address some perceived challenges with actually using a crypto currency, and there are also different approaches to the blockchain that support other coins, like Ether on the Ethereum network.

Chances are decent that you are more aware of Bitcoin and its brethren because the prices of crypto currencies have risen so dramatically in the last year; it is a basic function of a "bubble" or hot market that big gains in value attract attention, which inspires a desire to participate, which pushes prices higher, which causes the cycle to repeat...for a time.
So are crypto currencies in a bubble?  Sure.  Is that "bad"?  It depends on your perspective.  The primary aim of this post is to offer a framework for considering an individual investment in Bitcoin or one of the other coins, so I will pivot to that:

• A rational investment should be based on an expectation of economic gain
• The opportunity to realize an economic gain requires an ability to enter, hold (and collect any distributions like dividends or interest or rent), and/or exit the investment, inclusive of any related costs.
• From the perspective of an individual investor, any one investment opportunity should likely be considered within a broader context of their financial circumstances.  In the planning profession, we talk about assessing risk tolerance, defining financial goals, identifying available resources, and developing a comprehensive approach that ties all of those facets together into an actionable plan.

Applying those bullet points to Bitcoin (or similar) offers some insights, and raises some additional questions:

• Is there a rational expectation of gain for people buying into a given crypto currency coin at present?  There seem to be a few schools of thought on what the value proposition is for these coins:
  • A "store of value".  This line of thinking makes crypto coins analogous to gold, which some market participants have looked to for years as a hedge against fluctuations in their home currency (like the US dollar); the belief here is predicated on an assumption that if there were a major devaluation in the dollar due to macro economic or political shifts, gold may retain more relative value.  This belief is highly subjective, and the performance of crypto through cycles that historically benefited gold has yet to be seen.
  • "Anonymity". Some market participants desire a means of economic exchange that does not flow through the legacy banking system and is less visible to the government.  Crypto coins do seem to offer this opportunity, although there are still points of contact between the legacy systems and the blockchain, the anonymous nature of the system has produced some examples of "wild west" abuses within the system, and legacy banks and governments are making moves to pull the blockchain into alignment with the existing infrastructure.
  • A medium of exchange, independent of anonymity.  This may be the most prosaic view of the crypto currency future.  In this model, one or more of the current coins could turn into the default option for digital exchanges of value, i.e. how you pay for stuff. The total number of Bitcoin that will ever be mined is already set, built into the currency's nature from the beginning.  That programmed scarcity has some market participants convinced that there will be a steady demand for coins (or fractions of coins) by people just wanting some to use for quotidian purchases. 
    
    Do any of these points lead to a rational view that Bitcoin will trend higher from here?  Each of those possible vectors for expected growth involves a number of highly subjective assumptions that I am not confident to make at this time.
• What about the mechanics of investing in a crypto currency?
  • Early adopters in these markets have seen a number of "wallets" and exchanges arise to provide ways to buy, hold, and transact with their coins.  While the experience for many has been unremarkable (in a good way), there have also been a number of high profile failures with coins "lost", "destroyed", and stolen in ways that would seem foreign to people whose financial experience is limited to dealing in dollars and with established banks.
    With that in mind, it may be reasonable to assign a "carrying cost" to holding Bitcoin, with the cost less a financial one, and more a percentage chance of losing some or all of the holding due to quirks in the still developing infrastructure.
  • The current market in Bitcoin, Litecoin, Ether, etc suggests that there is presently a steady buy side demand for the coins; as mentioned above, this steady demand has been self-perpetuating, as new buyers push the prices higher, attracting new buyers, etc.  The sell side of the market, and how the market itself would react to demands for liquidity for future sellers, has been relatively untested -- and this is currently my own, personal preoccupation with these market as a potential "investment".  Having watched the stock and bond and real estate markets for a while, in both a personal and professional capacity, I have seen these supposedly mature asset classes go through cycles of paralysis, crisis, and illiquidity.  The very nature of the still nascent crypto currency market causes me significant concern about what a liquidity crunch would look like for these coins.
  • At present, there do not appear to be any sources of distribution-type returns from simply holding Bitcoin...as with gold, there are no dividends or interest or rents available to owners.  That may change in the future (maybe coin holders will be able to "lend" their currency to people who need some for transactions?).
  • There ARE transaction costs within the blockchain, and at least with in the example of the Bitcoin blockchain, those transaction costs (and times required to actually complete a transaction) have been rising, from a few pennies each time to as much as $20 or so.  These variable costs are in some ways analogous to commissions, and present a source of friction or drag within the network for exchanges of value.
    
    None of the above suggests that the actual process of buying, holding, and selling a crypto coin for a (desired and potential) profit is impossible, just that there are some legitimate challenges in the current scenario.
• Now, in terms of how an individual investor might perceive an investment in a crypto coin and place it within their overall investment framework, the thought process can be a bit more straightforward.
  For most individual investors, the best practice these days revolves around a basic approach:
  • Have an emergency fund in place before risking any meaningful money in the market
  • Have a clearly defined budget, and a good understanding of what resources are available to invest toward well articulated goals
  • Prioritize among goals, and make use of goal specific strategies for efficiency (retirement accounts for retirement goals, employer match for workplace retirement plans, etc)
  • Choose investments based on match to risk tolerance, investment objective, and time horizon, with a focus on low cost and diversity among the investment options
    
    In that framework, if a person were motivated to invest in Bitcoin (or similar), it may be most appropriate to treat it as one component within a larger portfolio, with allocation size determined by desired risk exposure.  By way of example, many investors may now focus their stock and bond allocations on internally diversified investment products, like mutual funds or ETFs.  A purchase of Bitcoin as an investment, in contrast, would look more like investing in a single company's stock; further, based on the relative volatility, size of the market, and potential liquidity constraints of Bitcoin, the comparison would need to be to a similarly sized and volatile stock...I'm thinking a bio-tech stock whose potential profit is entirely based on the unproven efficacy and eventual approval of a drug might be a reasonable analog.  It would be difficult to rationalize an investment allocating a large percentage of an investor's available resources to a highly volatile stock with a non-zero chance of failure and collapse; similarly, it would likely be inappropriate to commit those resources to an investment in a crypto currency, simply based on the risk of loss.

Everyone's talking about Bitcoin and the other so-called "crypto currencies".  Much of the present attention seems to be driven by a fairly typical "fear of missing out" bubble.  Investments in crypto coins have both idiosyncratic and traditional considerations for investors.  Proceed with caution!

Current and prospective clients of DRW Financial should feel free to email or call David with questions on how or if it is appropriate to incorporate an investment of this sort within their overall plan.

Many of the posts I write are as much for me as for anyone out there looking for new insights on their financial condition.  Today's is one such post.
I have written elsewhere about how our money choices reflect on our values, and that when there is conflict between what we say we value and how we live our values, there is an opportunity for self-reflection and a choice to align the two.

But where does ego fit into this discussion of values and money?  One example within my own budget and experience involves technology, specifically smartphones and computers.
I use an Android based phone and a Chromebook for my work and personal computing needs.  These choices were originally at least a bit driven by economics: iPhones are expensive and in the early days just having an iPhone required a specialized phone plan that cost more than average; similarly, a decent Chromebook costs around $200, while a similarly featured Windows machine might cost twice as much (or more), and a Mac might cost 3x - 4x just to get started.
But even though I may have started out with fiscal discipline in mind, what happened over time is that at each opportunity to replace or upgrade my equipment I would inevitably spend some time looking at the "nicer" options available.  A $200 Chromebook has proven to be sufficient, but the $600 one may be prettier and have some snappier specs...  The $150 - $200 "mid range" Android smartphone does 95%+ or more of what the current "top end" phone may offer, but there is always that voice in the background saying "wow, that fancy phone is cool​!"

This is where the budgeting rubber meets the road.  When faced with an option to spend more or less for essentially the same experience, it is crucial to be honest.  When explaining (to yourself or others) why you want the more expensive option, choose to have enough perspective to examine those reasons objectively.  It is so easy to justify a choice that we want to take, but it can be hard to be honest about the quality of those justifications.
Shopping while under the influence of vanity or with a heightened sense of your needs can lead to some financially unsound decisions.